May's Big Selloff Could Be Just the Beginning

By

Brett Arends

Updated May 30, 2010 12:01 a.m. ET

Are you ready for a lot more turmoil?

You had better be -- because there's a good chance that's what you're going to get.

Nobody knows for certain, of course. All stock-market predictions need to be taken with a little salt. But there are reasons to suspect that the sudden plunges of the past few weeks may be unhappy omens of what's to come.

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Like last week, with stocks lurching wildly with the headlines -- up by triple digits one day, down the next. For the month, the Dow Jones Industrial Average dropped 7.9% and is negative for the year. The Nasdaq Composite and the Standard & Poor's 500-stock index also are in the red for the year.

Some pretty smart people are cautious. Seth Klarman at Baupost Group is worried. John Hussman of the Hussman Funds says all sorts of warning lights have lit up across his screen. Even Ron Muhlenkamp of the Muhlenkamp Fund, who usually takes a sunnier view of things, says he has moved a big chunk of his mutual fund into cash in case there's a plunge.

How far will it go? Mr. Hussman says the technical indicators have only been this bad 19 times before in the last half century -- and on average the market plunged about 20% over the following 12 months. When markets were also high, like now, the picture's even worse.

Ugh.

Too many people have simply assumed that the last 14 months have been the start of the next boom. But it may have been a typical "bear-market rally" doomed to fall flat on its face.

That's what stock-market historian Russell Napier says. He thinks we're in a giant, generational slide that began in 2000 and has several years still to run.

We forget that the stock market moves in long, decadal swings. Slumps like those in the 1930s or the 1970s, or in Japan after 1990, weren't simple, straight-down affairs. They were punctuated by huge "sucker" rallies that eventually faded away. But, over all, the market bounced along sideways, or down, for a decade or two.

Two Decades?

The slide that began in 1969 didn't end until 1982. The slump after 1929 didn't give way until the late 1940s. Japan's gloom is still with us.

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Lisa Haney

In general, the bigger the bull-market boom, the bigger and nastier the bear market that follows. The bull market of the '80s and '90s was the biggest on record. So expect the bear that follows to be ugly and tenacious.

Mr. Napier has studied the big stock-market grizzlies of the past. Generally speaking, they took a long time to die, and didn't do so until shares got really, really cheap.

March 2009? Not even close.

He fears Wall Street could fall by half, or worse, over the next four years before this bear is finally slain. Very few are that apocalyptic. But plenty fear more choppy times to come.

As one respected fund manager told me not long ago, Wall Street had spent too many years overvalued, from 1994 through 2008, for last year to mark the end of the reckoning.

Either way, stock markets today simply look too high. Based on certain long-term measures -- such as comparing share prices to asset costs or normalized profits -- Wall Street could be as much as 50% overvalued.

And then there's the economic backdrop.

It's not just the headline news out of Europe that has gotten people spooked. The problems are deeper.

This recession wasn't a normal one, so the recovery probably won't be either.

This slump wasn't caused by the economy "overheating," but by overborrowing -- on a massive scale, and over many years. It took place here, and in many countries around Europe, too.

Debt Hangover

The debt levels are without precedent. The bailouts have transferred a lot of private-sector debt to the public sector. But that's just moving the problem around.

The debt leaves a terrible drag on the economy as people try to save. And it is putting some countries' financial stability in question.

Inflation may yet come in due course. But Van Hoisington, a veteran bond manager from Austin, Texas, recently warned that the more imminent danger might be deflation -- falling wages and falling prices.

This is what has hammered Japan all these years. It's what turned the Crash of 1929 into the Great Depression. Deflation makes debts bigger in real, purchasing-power terms.

Where does that leave the regular investor?

Take a hard look at what you own, and what sort of downturn you think you could handle.

Too many investors -- and too many financial advisers -- are still running with the bull-market playbook: Take on risk; stay fully invested; buy the dips; equities always outperform.

Maybe it will work again -- if we have another bull market.

Are you really willing to bet your stack on that happening now?

A lot of very risky assets have boomed in the past 14 months. Investors in things like high-yield bonds and small-cap stocks have had a great ride. But if you couldn't stomach another plunge, you may want to scale back.

On the other hand, one should never get too gloomy. As a wise fund manager once told me, "Just remember, the economic fundamentals always look terrible!" And right now some blue-chip stocks -- here and overseas -- offer reasonable values. They may offer a good trade-off between risk and reward in this environment.

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